Eurozone borrowing costs soar on fears of fiscal hit from Iran shock
Government bonds face one of worst months of past decade as investors warn of ‘deterioration’ in public finances
Eurozone government bonds are heading for one of their worst months of the past decade, pushing borrowing costs for some countries to multiyear highs as investors grow nervous about the effect of the Iran shock on the region’s public finances.
Italy’s 10-year borrowing costs climbed as high as 4.14 per cent on Friday, their highest since mid-2024, amid a global bond sell-off driven by inflation fears from surging oil and gas prices. The yield later fell back to 4.08 per cent but was still up almost 0.8 percentage points so far this month, rivalling a similarly sized sell-off during the region’s last energy crisis in 2022.
In volatile trading, France’s 10-year yields touched an intraday high on Friday of almost 3.9 per cent, their highest since 2009, while Spain’s rose close to 3.7 per cent for the first time since late 2023.
The bonds have been hit this month as traders rushed to bet on the European Central Bank raising its benchmark interest rate three times this year to contain an expected burst of inflation.
“Investors are starting to realise that we are moving into a mix of lower growth and higher inflation, combined with more fiscal stimulus and higher government spending,” said Tomasz Wieladek, chief European macro strategist at T Rowe Price.
“The spectre of inflation has returned,” said ECB executive board member Isabel Schnabel in a speech on Friday afternoon, adding that the shift had happened faster than “many people” had expected. But the ECB did not need to “rush into action”, she said, and had “time to look into [the] data” for evidence of second-round inflationary effects.
Fund managers said the rise in longer-dated yields was being exacerbated by the expected hit to public finances of higher borrowing costs and measures to protect consumers from rising prices.
Spanish lawmakers on Thursday approved a package of tax cuts worth €5bn designed to soften the blow of higher energy prices. The cuts, proposed by leftwing Prime Minister Pedro Sánchez, will reduce VAT from 21 per cent to 10 per cent on electricity, natural gas and fuels.
Italy has temporarily cut fuel excise taxes by 20 per cent — a measure that will cost €417mn until April 7, when it is due to be reviewed. Rome intends to make up for the lost revenue with spending cuts elsewhere, including on healthcare.
Investors are betting that public finances across the Eurozone “are going to deteriorate”, said Jean-François Robin, global head of research at Natixis CIB, as countries spend “a lot of public money” to absorb the shock.
Following the start of the previous energy crisis in September 2021, €651bn was allocated and earmarked across European countries, including the UK and Norway, to shield consumers from rising energy costs, according to the Bruegel think-tank.
The OECD said this week that many of the measures taken then were “poorly targeted with significant fiscal costs” and warned that measures to cushion the impact of higher energy prices this time would “add to the budgetary challenges that most governments now face”.
Simone Tagliapietra, a senior fellow at Bruegel, said the measures announced thus far by governments including Spain suggested that “we are talking big money” as countries consider their options.
“European governments are under fiscal constraints, we have a lot of competing necessities, not least defence spending, and public budgets are constrained,” he said. “I do not see the fiscal space to put in place measures like we did in 2022 and 2023.”
In France, the government is trying to hold the line by not enacting broad aid to cushion energy prices, with the prime minister saying the deficit of 5.1 per cent of GDP at the end of 2025 meant that there was “no piggy bank”. It has instead introduced some targeted measures for industries that are set to be hard hit, such as agriculture and trucking. The measures will last for the month of April at a cost of €70mn.
The bond sell-off has put into reverse what had been a years-long rally in the Eurozone’s so-called periphery, borrowers that had been the focus of past debt troubles, relative to Germany.
The additional interest rate that investors demand to buy Italy’s bonds over Germany’s — a widely watched measure of investor anxiety over Eurozone debt — was about 0.6 percentage points before the conflict. It has since risen back to almost 1 percentage point.
Bert Colijn, an economist at ING, said part of the move could reflect an unwinding of investors’ positions betting that spreads would tighten further, for example in Italy. While he did not detect significant concerns about the risks attached to Eurozone sovereigns, “that could still come into play if this lengthens and perhaps fiscal measures become more expensive”.
Eurozone spreads remain modest in historical terms — Italy’s spread hit 3 percentage points during the Covid sell-off — and investors said they did not present an immediate wider concern.
The “current widening does not invalidate the longer-term spread tightening story”, said Konstantin Veit, portfolio manager at bond giant Pimco, adding that it would take several years of high interest rates and low growth to trigger questions about debt sustainability.
But some warn that a further rise in the benchmark 10-year Bund yield — which sets a reference point for the Eurozone and has been rising in part due to Germany’s plans to increase spending — from its current 3.1 per cent, could push borrowing costs for other Eurozone economies into less comfortable territory.
In a scenario where the Bund yield climbs above 3.5 per cent and borrowing costs for Italy and France are pushed closer to 5 per cent, “debt sustainability becomes uncertain”, said T Rowe Price’s Wieladek.